Much Sound and Fury, but Little Change in First Quarter Markets

May 2, 2016 – Unlike some previous quarters, there is certainly no shortage of issues to talk about for the first quarter of 2016. Capital markets gave us a little bit of everything from both an economic and a performance perspective. In the end, however, it all amounted to a lot of sound and fury with only small gains or losses across most asset classes.

Investors looking for signs of a lurking bear could seize on a legitimate growth scare to reinforce the belief that the world is approaching the end of a prolonged period when central bankers could manipulate asset prices through their policy actions – and sometimes even with their words. On the other side, those with a more bullish mindset focused on the good news that came in the middle of February when growth was better than people thought it would be and markets quickly reversed their downward trend.

At quarter end, the debate was still unresolved and the market’s likely future direction still unclear. The bears believe the period of unprecedented central bank influence is ending and that banks won’t be able to move the world into a period of recovery without a significant economic displacement. Conversely, the bullish pundits say expectations have gotten so low that it won’t take much good news to push capital markets higher.

Over the course of the first quarter ups and downs, one core Pitcairn principle was unequivocally validated. Market timing remains a loser’s game. The sentiment of many investors worked to their own disfavor during the first quarter, as is often the case in times of uncertainty. As equity markets moved lower in the early weeks of the quarter, investors lost confidence and many jumped ship at just the wrong time. In fact, shortly after quarter end, the head of a well-known mega investment company reported that his company saw massive equity outflows during the early part of the first quarter, including a huge outflow on February 12, exactly the day the market bottomed and just when market timers should have been moving into equities.

Stocks have gone straight up since then. And Pitcairn clients were positioned to benefit from the recovery because we provide the support necessary to sustain confidence in a long-term investment plan even in the midst of storms.

Global Economy

The global economy experienced weakening growth across many theaters, providing the spark that set off the equity downturn early in the quarter. (See Chart A.) Fears that China would go from the world’s growth engine to the driver of its next recession have been at the root of the last two significant market declines. Both times, markets recovered. China’s government is actively trying to address its economic challenges, taking steps to stimulate the economy and address bad debts in its financial system. Whether through central bank policy or government fiscal policy, it seems likely that China’s leaders will intervene to do what it takes to maintain a level of growth that keeps the global economy from going off the cliff.

China’s economic data has been improving, including a very strong export number released in early April. For those who doubt the veracity of China’s government data releases, we acknowledge the need for skepticism and we don’t take them at face value. However, we’re seeing results in Korea, Indonesia, Singapore, and Malaysia that all show similar trends, so we have confidence that China’s situation is improving.

Though actual global growth remains anemic, investor sentiment related to that growth has swung remarkably to the positive since mid-February. However, there are still challenges ahead. In June, British citizens will vote on whether or not to stay in the European Union. Consensus is that the UK will stay, but if that belief comes into question, it’s likely currencies will destabilize as people try to understand the implications of a UK exit.

Interest rate trends are also likely to further affect currency markets. Major central banks across the globe, including Japan and Europe, have gone from low or zero interest rate levels to negative interest rate policies. Unfortunately, those moves don’t seem to be having the effect central bankers intended them to have. In fact, the yen went up rather than down when Japan went to negative interest rates.

In the past, we have noted that one of the markers of a bear market is an inverted yield curve. When a yield curve inverts, it means buyers of longer maturity bonds reject the validity of central bank actions in the short end of the yield curve. We’ve not seen that yet, but it does seem as though global currency markets are beginning to reject the framework of central bank policy as evidenced by the yen rising as Japan’s central bank moved to negative interest rates.

Even though total return from global equity markets was generally flat, results from other assets were noteworthy, including a downward turn in the price of gold, a recovery in commodity prices, particularly oil, and the rebound in emerging markets. All of these asset classes have been quite weak for some time now and all turned in the first quarter.

US Economy

In the past several quarterly letters, we have talked about the US dollar rising to the ceiling, while oil was in the cellar and how both extremes were impeding S&P earnings. A strong dollar and weak oil prices are primary causes for the recent earnings recession that centered on the energy sector. I have also said that if we saw either or both of those trends change – if the dollar stopped rising and/or energy prices stopped falling – markets would suddenly have a tailwind rather than a headwind. That’s precisely what happened in the first quarter when we saw a large jump in the price of oil (from $26 to $41 a barrel) and a weakening of the US dollar. (See Chart B.) Part of the improved investor sentiment during the second half of the quarter was due to the better economic outlook supported by the jump in oil. The price of oil has always been notoriously difficult to forecast, so it’s impossible to conclude that the first quarter pop means oil will keep rising from here, but an upward trend has been established.

In terms of US economic activity, we should all be prepared for an ugly first quarter GDP number; growth could come in at 0.5% or as low as 0.2%. However, a weak first quarter GDP doesn’t mean a recession is imminent. In fact, the changes in economic indicators between January 1 and today have been nearly all positive, particularly in the US, but also in other parts of the world. It’s also important to note that for the past several years, first quarter US GDP has been very weak. Some of those weak numbers were subsequently revised higher, but regardless, what’s most meaningful is not quarter-to-quarter GDP, but the longer term trend. And for the US, GDP growth has been about 2% annually for the last five to six years. We are still not too far from that trend.

Back in June 2015, manufacturing data from the ISM (Institute of Supply Management) indicated expansion. Then, we had the massive fall in the price of oil from $100 to $80 to $60 to $40 to $20. Suddenly, manufacturing data didn’t look so good. Energy companies were the first victims of the lower oil prices, but it also affected broader economic growth as companies stopped spending and cut resource expenditures. Much of the focus has been on this short-term impact – the negative effect from reduced corporate spending. However, lower energy costs also mean more disposable income for consumers and the longer-term positive is that they ultimately spend that extra income. I think we are now starting to see a shift toward this longer-term benefit of low oil prices.

On top of potential consumer spending increases, we are also seeing improvement in the US manufacturing segment. Companies are putting some capital back to work and ISM indicators are once again starting to signal economic expansion. Improving earnings, improving growth and improving spending should all bode well for 2016 economic growth in the US. (See Chart C.)

As I write this letter, we’ve only had a few days of corporate earnings releases, but if early reports are a reliable indicator, it appears that companies are beating expectations, which are admittedly really, really low. Historically, 65%-67% of companies beat their expectations, a high percentage that shows corporations are effective in managing analysts’ expectations. Whether we reach that percentage this quarter remains to be seen, but it seems like this should be a reasonably good quarter for corporate earnings, yet a challenged one for corporate revenue, as has been the case for this market trend.

The Fed had planned four interest rate hikes for 2016, but by early in February, Fed Chair Janet Yellen predictably stepped up to calm market fears by taking two of those raises off the table. Her comments about global growth were decidedly dovish, suggesting that the Fed’s pace of interest rate increases would be slower than previously expected by investors. Unlike when former Fed Chair Alan Greenspan executed a series of rate increases resembling a steadily rising flight of stairs, we always expected Yellen’s Fed to implement a rate raise or two and then sit back to see what happened. Unfortunately, Yellen’s first rate increase in December came just before a period of slowing global growth so it had a worse effect on Fed psyche than it would have had earlier in 2015. Yellen’s own rhetoric suggests that she believes the economy could slip into deflation if the Fed doesn’t maintain an easy money stance. Given her perception, it’s unlikely the Fed will err on the side of aggressively raising rates. Though officially the Fed is still saying two rate raises in 2016, I think it could be one and done.

The main takeaway for the US economy is mounting evidence to refute the recession thesis that ruled investor sentiment late in December and early January. We have resisted recession predictions and markets now seem to be coming around to our thinking on this subject.

Global Equities

On the first trading day of January, China’s government implemented a volatility dampening scheme that backfired, increasing volatility rather than reducing it. This was one of a number of factors contributing to global market upheaval, but it’s worth noting that China-in-crisis has incited both major market pullbacks we have had in the past year – the tumult in July 2015 and the downturn from January 1 to February 12, 2016.

Among developed markets, the US clearly led the equity recovery in late February through March. This wasn’t surprising given that the US had been the most volatile on the market’s way down in December and January. Elsewhere in the world, European and Japanese equities were weak in the first quarter as investors repudiated negative interest rate policies (NIRP) in both regions. Meanwhile, Canadian and Australian equities benefited from higher commodity prices and currency effects.

Along with other notable reversals late in the first quarter (gold, commodities, and sentiment toward China), we also saw some healthy action in emerging markets; the first time emerging market equities have outperformed developed markets since the second quarter of 2015.

Brazil contributed to the sharp gains in emerging market equities with an incredible performance from its stock market, but the country is still mired in political crisis. Brazil’s headline news was far from pretty: the former president was detained in connection with the ongoing corruption investigation, the current president came under threat of impeachment (which subsequently occurred), and the vice president accidently released his presidential acceptance speech before impeachment proceedings began. All in all, not a picture of government stability. Certainly, the rebound in commodity prices was a positive for Brazil’s stocks and the prospect of a leadership change even via impeachment may have played a role. However, our deeper research (including conversations with our Wigmore Associate members in Brazil) suggests that many buyers of Brazilian stocks in the first quarter were US hedge funds. At the same time, Brazilians themselves are cautious and are still moving money out of their country. I would anticipate that many of these hedge fund investors are now eyeing a quick exit after this quarter’s almost 30% gain in Brazilian equities. Consequently, we don’t believe this is a sustainable rebound for Brazil and we remain skeptical about the current outlook for this market until we see a more stable economic and political climate.

Though international equities (excluding emerging markets) underperformed the US again in the first quarter, we really believe there are going to be opportunities globally. We are convinced that investors should maintain exposure to all markets, US and non-US, developed and emerging. Without well-diversified exposure, many investors would have missed the uptick in emerging markets this past quarter. Furthermore, we believe there’s a good chance that the global non-US equity picture will improve over the next 12 to 15 months.

US Equity

As we noted above, US stocks led the world’s developed equity markets in the first quarter – on the way down and the way back up again. The S&P 500 returned 1.4% for the first quarter. Value stocks prevailed across all market capitalizations – large, mid, and small cap stocks, as we’ll discuss in more detail below. In terms of size, mid cap US stocks were the best performers, followed by large cap. Unfortunately, small cap stocks did not participate in the rally as much as we would have liked and ended down for the quarter as the general flight-to-safety trend favored larger, more valued oriented stocks.

There were some positive trends evident in the US market’s late quarter rebound. At the end of last year, we complained that the market’s performance was very narrow – with just the 10 largest stocks responsible for the bulk of the S&P 500’s gains. The past quarter’s large cap rally was much healthier in terms of breadth. The fact that the equally-weighted S&P 500 Index outperformed the capitalization-weighted S&P 500 Index is evidence of that health.

Some people may cite the appetite for equities in the recent rally as proof of investor exuberance, one of the signs that a bull market is in its final stages. But this rally was led by yield stocks like Johnson & Johnson, McDonalds, and Coca-Cola. These traditional value stocks are not companies investors buy in the throes of exuberance. In a late bull market, investors chase high-flying growth companies, not solid dividend payers. We don’t believe people are buying yield stocks because they’re feeling especially bullish. Rather, investors are hungry for yield in what is still an extremely low interest rate environment. If they can get a 3%-4% dividend with the bonus of possible equity appreciation from a company that nobody thinks is going broke, they’re going to do that. That’s not exuberance, it’s practicality.

So if yield stocks were the drivers during the recent rally, who was in the back seat? Over the past three to four years, the market’s outperformers have mainly been in the pharmaceutical and technology sectors. Many of these companies did not participate in the recent rally. We can blame some of their fall from favor on how far the stocks had already risen – maybe too far, too fast. These companies deliver growth, but have been very, very popular. Another catalyst for the reversal was probably a change in sentiment – a little bit more fear that is leading investors to stocks that will pay them now via dividends rather than in the future via earnings growth. As a result, a severe shift in stock market leadership during the first quarter affected active investment managers. Those who had performed well over the last few years probably didn’t perform as well in the first quarter. The change in trend is especially evident in the performance of momentum stocks. (See Chart D.) After four years in which markets rewarded price momentum, these stocks reversed dramatically in the first quarter. This reminds us that market leadership can change on a dime, as it did this past quarter and reinforces the benefits of the multi-manager investment approach that Pitcairn employs.

Looking forward, we remain bullish on US equities, a position that has not changed in recent years. US equities have moved a long way in a short time, so any bad news – such as a poor US GDP number — could cause some short-term angst, but as always, our recommendation is to focus on the long-term story. We see no reason for the dollar to go rocketing up, energy prices seem to have bottomed, and it’s very possible oil prices could go higher. All of this suggests better-than-expected earnings for US companies.

Fixed Income

Core fixed income delivered solid returns in the first quarter, benefiting from a flight to quality due to the global growth scare and from a decline in interest rates following reassuring comments from central banks. In short, the long-awaited inflationary environment has still not arrived. Many market participants seem to be coming around to our view that the Fed and all central bankers are going to maintain easy monetary policies for some time and that there might be some validity to the deflationary pressures that are so worrisome to central bankers. This means there are opportunities in fixed income as well as equity.

More important than the fact that the 10-year Treasury went nowhere during the quarter, and might not go anywhere for 12-24 months, is the general state of credit conditions. One of the factors that exacerbated market fears in December and January was a real dislocation in the credit markets. In particular, yield spreads between debt securities of energy issuers and US Treasuries widened significantly, causing substantial underperformance in the sector. That underperformance reversed significantly in the latter half of the first quarter, particularly in high-yield bonds, which moved higher in a hurry just like equities. As a result, we think the high-yield market might actually be a little ahead of itself now.

Contrary to the high-yield market, the more normalized fixed income market indicators – B/AA-rated sectors – signaled a more stable environment. In our view, credit conditions are more influential over equities in a 6-12 month time frame. I would actually be more concerned if yield spreads between Treasuries and non-Treasury fixed income sectors started to reverse themselves and expand than if GDP growth came in unexpectedly weak. In this slow growth market, it’s vital that we stay abreast of credit conditions and the implications for borrowing and businesses’ ability to grow or not.

A key question going forward is how bond markets will react if the Fed slows or even halts its march toward a more normal interest rate policy. Despite some signs of growing frustration with central bankers across the globe, it seems to us that the Fed has done a better job than most people give it credit for, particularly since there has been absolutely no support from government spending. Over the last five years, many have fixated on the ways that the Fed’s actions and those of other central banks could lead to disaster. But, the people who have actually made money in recent years are those who were open to the ways in which Fed policy might NOT be a disaster. Of course, things change and investors could quickly become disenchanted with Fed policy, but we don’t see that happening because fundamental US economic growth is better than most people think.

Real Assets

In terms of real assets, the rising oil price and rebound in other commodity prices was clearly the quarter’s biggest story. The stabilization in oil and commodities rewarded investors who stuck with these segments and with master limited partnerships, more evidence supporting the benefits of diversification. Just when no one wanted to have anything to do with emerging markets or commodities, they were top performers. (See Chart E.)

In other areas, REITs were strong for the quarter, up 5.2% globally. Low interest rates and low inflation are a potential tailwind for REITs, but the sector may come under pressure when rates eventually rise.

Alternative Investments

On the whole, hedge funds continued to struggle in the first quarter, though there were both pockets of strength and high profile managers who performed quite poorly. We still think the underlying cause of hedge funds’ modest performance is the slowly evolving nature of this market environment. From the perspective of hedge fund managers, not much has changed from 12-18 months ago. Interest rates have not moved much and are still exceptionally low, equities are still the number one game in town, and there’s still not quite enough negative correlation between asset classes to provide fodder for hedge fund managers to achieve their returns.

Equity-oriented hedge managers were under particular pressure in the first quarter due to the reversal in stock market leadership that we discussed above. This reversal affected hedge funds even more than other active managers because hedge funds are more concentrated and more leveraged and they tended to have large positions in stocks that had been in favor, but were no longer in favor. On the other hand, hedge fund managers who were investing in higher-yielding fixed income and moving down the capital structure – even into distressed securities – saw improvement in the last three to four weeks of the quarter. Again, this supports having balance in a portfolio. We don’t just lump hedge funds into one bucket. We see them as an extension of a portfolio’s main asset classes, with diversification across the variety of equity and fixed income hedge strategies.

Conclusion

Last July we pointed to oil prices, China, and the Fed as the market’s key concerns. We have since seen worries about China and oil subside, though preoccupation with the Fed continues. As we move through the coming spring and summer, politics could be the market’s next wall of worry, but I don’t think it will be an insurmountable one. Uncertainty is typically the biggest threat to market sentiment and there now seems to be growing consensus that Hillary Clinton will be the next president. Regardless of personal views, the fact that Clinton is a known quantity may be what matters most to the markets. Furthermore, markets typically prefer a legislature and President split between the two parties because that favors the status quo. Should there be some new dynamic introduced over the summer, this story could change, but for now I don’t see politics as a significant hurdle.

Revisiting a theme we introduced several years ago, I would just like to reiterate that it is a lot easier to lose money reacting to the current political environment than one might think. Though we are certainly going to keep a close eye on this year’s election, we think it’s best to wash the short-term political impact out of long-term investment thinking. There have been numerous times where we have made good decisions and made money because we ignored the slings and arrows of the current political environment to look deeper and longer at more meaningful trends.

The first quarter roller coaster ride gave investors plenty of reason to veer from long-term investment plans. I would just like to remind you that history is clear: markets like this will occur periodically and that’s why the potential impact of poor performing markets – even markets extreme as 2008 or 1987 — are included in every financial plan at Pitcairn.

We still can’t be entirely certain whether the market’s recovery at the end of last quarter is a real rebound or the last gasp of a bull market, but we believe that over the next decade or two, the tremendous power of consumers, especially outside the US and particularly in China, will be harnessed in a way that is positive for capitalism, the global economy and global stocks. Furthermore, we are resolute in our belief that the core asset classes that created and sustained wealth in the past will continue to do so in the future.